The authors believe that their three-factor model can account for the over-
reaction evidence, but not for the continuation of short-term returns (un-
derreaction). This evidence also presents a challenge to behavioral finance
theory because early models do not successfully explain the facts.^4 The
challenge is to explain how investors might form beliefs that lead to both
underreaction and overreaction.
In this chapter, we propose a parsimonious model of investor sentiment—
of how investors form beliefs—that is consistent with the available statisti-
cal evidence. The model is also consistent with experimental evidence on
both the failures of individual judgment under uncertainty and the trading
patterns of investors in experimental situations. In particular, our specifica-
tion is consistent with the results of Tversky and Kahneman (1974) on the
important behavioral heuristic known as representativeness, or the ten-
dency of experimental subjects to view events as typical or representative of
some specific class and to ignore the laws of probability in the process. In
the stock market, for example, investors might classify some stocks as
growth stocks based on a history of consistent earnings growth, ignoring
the likelihood that there are very few companies that just keep growing.
Our model also relates to another phenomenon documented in psychology,
namely conservatism, defined as the slow updating of models in the face of
new evidence (Edwards 1968). The underreaction evidence in particular is
consistent with conservatism.
Our model is that of one investor and one asset. This investor should be
viewed as one whose beliefs reflect “consensus forecasts” even when differ-
ent investors hold different expectations. The beliefs of this representative
investor affect prices and returns.
We do not explain in the model why arbitrage fails to eliminate the mis-
pricing. For the purposes of this chapter, we rely on earlier work showing
why deviations from efficient prices can persist (De Long et al. 1990a,
Shleifer and Vishny 1997). According to this work, an important reason
why arbitrage is limited is that movements in investor sentiment are in part
unpredictable, and therefore arbitrageurs betting against mispricing run the
risk, at least in the short run, that investor sentiment becomes more ex-
treme and prices move even further away from fundamental value. As a
consequence of such “noise trader risk,” arbitrage positions can lose money
in the short run. When arbitrageurs are risk-averse, leveraged, or manage
other people’s money and run the risk of losing funds under management
when performance is poor, the risk of deepening mispricing reduces the size
of the positions they take. Hence, arbitrage fails to eliminate the mispricing
424 BARBERIS, SHLEIFER, VISHNY
(^4) The model of De Long et al. (1990a) generates negative autocorrelation in returns, and
that of De Long et al. (1990b) generates positive autocorrelation. Cutler et al. (1991) combine
elements of the two De Long et al. models in an attempt to explain some of the autocorrela-
tion evidence. These models focus exclusively on prices and hence do not confront the crucial
earnings evidence discussed in section 2.